Which pass-through will pass?

With both houses of Congress making progress on their respective tax reform bills, experts are turning their eyes to the conference process – where one issue is looking particularly thorny for the conferees.

“The House and the Senate bills are not that far apart with regard to the corporate and the individual provisions,” observed Howard Wagner, managing director at Crowe Horwath LLP. “But they’re very far apart on taxation of pass-through income, and that’s where they’ll have to reconcile their differences.”

“The Senate bill has a 17.4 percent deduction for qualifying pass-through income, while the House bill taxes it at 25 percent,” he said. “But the House bill has a 70-30 split, and treats active and passive participants differently. For example, suppose I’m a 50 percent investor who is an employee of a pass-through. Only 30 percent of my salary and K-1 income would qualify for the 25 percent rate, while the other 50 percent investor, a passive investor who gets no salary, would receive 100 percent of his income from the business at the 25 percent rate. Capital-intensive businesses can get a greater portion of income eligible for taxation at the default 25 percent rate.”

“The two proposals are quite different,” agreed Mike Antonelli, a tax partner at Edelstein & Co. LLP. “It’s difficult to get into too much detail on potential changes at this point. Even trying to wrap around how they would administer and police this is complicated, because there are different exceptions, different income levels, and varying applicability depending on the type of industry.”

“The House bill provides a special reduced tax rate for active owners earning less than $150,000 in taxable income, subject to a phase-out,” said Paul Dougherty, an EisnerAmper tax partner. “Some lawmakers feel this treatment does not go far enough because many small-business owners are not in the highest tax bracket and, consequently, will not feel the impact of this relief.”

“The Senate approach, allowing a deduction for pass-through entities in lieu of a change in rates, ostensibly provides relief for all taxpayers,” he added.

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“Clearly both the House and the Senate think we need to do something for pass-throughs, but their ideas are radically different,” said Roger Harris, president of Padgett Business Services. “So until we get to conference, it’s hard to know which of these two proposals will prevail – or whether they will come up with a third one we haven’t heard about.”

“A lot will be left to the IRS,” he continued. “The Senate does a good job of trying to explain ‘qualified business income,’ but the IRS has to go in and think of every possible crazy scenario and give guidance -- for example, when does salary count? It sounds complicated, and it’s actually more complicated than it sounds.”

“Any time you offer special deductions and special tax rates, complexity comes with it because you have to try and prevent people from abusing those rates and deductions. It’s the normal tradeoff we get in taxes,” he explained.

The Senate bill now has to go to the full Senate for debate, amendments and a vote, and all this has to be done soon, observed Harris.

“With a current 51-49 vote majority, the margin of error will potentially shrink on December 12, [the date of the special election for the vacated Senate seat in Alabama],” he said.

Tom Wheelwright, founder and CEO of accounting firm ProVision PLC, offered this example comparing the effects of the Senate and House provisions. “Two companies, one a C corporation and the other a flow-through, each make $1 million,” he said. “Assume for now that they’re not service companies. What the House bill did was give parity to a flow-through vis-a-vis a C corporation. The C corporation will pay $200,000 at the tax rate of 20 percent, and if it distributes the remainder of $800,000 as a dividend to the shareholders, they will pay 15 percent tax, or $120,000. Add the two -- $200,000 plus $120,000 -- equals $320,000, so the effective tax rate is 32 percent.”

“With regard to the flow-through, they’ll get a rate break of 25 percent on 30 percent of the income,” he continued. “Twenty-five percent of $300,000 is $75,000, while 35 percent [the individual rate] of $700,000 is $245,000. When you add the two together, you get $320,000, an effective rate of 32 percent which is exactly the same as the C corporation.”

“In the Senate bill, the 17.4 percent deduction for flow-throughs applies to everyone, so the Senate proposal actually gives a benefit to lower-income businesses that the House bill does not give. And under the Senate proposal, CPA firms and other service providers can get the benefit of the 17.4 percent deduction on income up to $500,000.”

“Moreover, under the Senate proposal, CPA firms would get the benefit of the 20 percent corporate rate if they decided to operate as a C corporation,” Wheelwright said. “So the policy purpose of the 30-70 split in the House bill is to bring the two entities to parity. The Senate bill has no policy purpose, it’s, ‘How do we get this thing passed?’”

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